Time to look again at inflation-linked bonds?

After years of being under-invested and under-researched, and as inflationary pressures grow, it’s time for investors to consider reassessing their exposure to inflation-linked bonds.

14/10/2016

Michael Lake

Investment Director, Fixed Income

Ultra accommodative monetary policy has inflated asset prices, but has had little impact on consumption of goods and services.

This combined with low commodity prices, particularly oil, has taken headline inflation to artificially low levels.

As a result, market expectations of future inflation have dwindled and participants have profited from further monetary stimulus through exposure to nominal bonds that have increased in value while interest rates have idled at or below zero.

Such large scale fiscal expansion would likely entail higher government spending or tax breaks that would impact final demand by directly stimulating the economy through development of infrastructure resources.

Such measures are likely to be inflationary and could be a boon to inflation-linked bonds, but do investors need to wait to see firm announcements of such policies before investing?

Inflation expectations

Inflation-linked bonds pay income that is adjusted based on official headline inflation data; however, demand for inflation-linked securities is driven by expectations of future inflation.

Currently, financial markets have extrapolated low levels of official inflation into the medium term. We believe this represents an opportunity. Should inflation expectations increase, and we believe that they could, active investors could profit.

Energy impact

One of the key components of headline inflation and a major driver of low inflation in recent years has been the sharp decline in the price of energy costs, primarily oil, the cost of which declined over 60% from mid-2014 to early 2016.

As headline inflation is calculated on a rolling 12-month basis the impact of the fall in oil prices diminishes with the passing of time and providing the price of oil does not fall further.

Indeed, from the trough established at the start of 2016 oil has rebounded over 50% and the impact of the fall in the price of oil will pass out of the calculation period in the first quarter of 2017.

Core inflation which excludes energy is currently higher than headline inflation and as the base effects pass out of the calculation headline inflation should begin to converge on core inflation.

While the mechanical impact of the change in energy prices and the rolling nature of the calculation of recorded inflation are important aspects to be considered, they alone do not argue for a sustained and long-term increase in inflation.

Demand increase required

There are increasing signs that global inflationary pressures are starting to build with commodity prices, input prices and tightening of labour markets all contributing to growing concerns regarding potential future inflation.

However, any sustained uplift in inflation would need to see the type of increase in demand for goods and services that could be the result of increased government spending.

In that vein, the recent Brexit shock, which itself caused a spike in UK inflation expectations given higher “imported inflation” from a weaker currency, has led to a less austere response from the UK government which is now openly discussing the prospect of direct government intervention to stimulate the economy.

Convergence of inflation drivers

In Europe, Mario Draghi, President of the European Central Bank (ECB), has regularly called for government reform to simulate economies and the Bank of Japan stated that it would aim to overshoot its inflation target.

Meanwhile, with the US election fast approaching, the policies espoused by both Republican and Democratic nominees are expansionary in nature.

Arguably therefore, both the technical and government policy drivers of inflation expectations appear to be converging.

We believe investors who continue to overlook the inflation-linked asset class are therefore excluding a potentially key source of return from their opportunity set.

The information on this website is intended solely for use by Singapore residents.

The funds mentioned are Singapore- authorised and recognised funds registered for sale or purchase in Singapore. By proceeding you are representing and warranting that you are either resident in Singapore or the applicable laws and regulations of your jurisdiction allow you to access the information. In particular, the information is not for distribution and does not constitute an offer to sell or the solicitation of an offer to buy units in Schroder funds in any jurisdiction where such activity is prohibited including the United States of America.

The contents on this website are for information only and without consideration given to the specific investment objective, financial situation and particular needs of any specific person. You may wish to seek advice from a financial advisor before purchasing units of any Schroder fund. In the event that you choose not to seek advice from a financial advisor before investing in any fund, you should consider whether the fund selected is suitable for you.

Past performance and any forecasts are not necessarily indicative of future performance. The value of units and the income from them may fall as well as rise. The funds are subject to investment risks. You should read the relevant prospectus obtainable from this website before investing.

The material and information on this site is current at the date of publication and is provided on an "AS IS" basis and without without any warranties of any kind, either expressed or implied.

To the best of the knowledge, information and belief of Schroder Investment Management (Singapore) Ltd ("SIMSL"), all information contained herein is accurate as at the date of publication. However, SIMSL or its affiliates or any director or employee of SIMSL or its affiliates cannot and does not warrant, guarantee or represent, either expressly or by implication, the accuracy, validity or completeness of such information.

Under no circumstances may the information contained herein, or any part thereof, be copied, reproduced or redistributed without the express permission of SIMSL. SIMSL or its affiliates, any directors or employees of SIMSL or its affiliates shall not be liable for any damages arising from any person's reliance on such information and shall not be liable for any errors or omissions (including but not limited to errors or omissions made by third parties) in such information. The information provided herein is subject to change without further notice.

Schroder Investment Management (Singapore) Ltd is regulated by the Monetary Authority of Singapore and is a member of the Investment Management Association of Singapore (IMAS).

We use cookies to help improve your experience with this website. By using this site, you agree that we may store and access cookies on your device. Cookies are small text files, downloaded onto your device, that tell us which pages you've visited, when and what your technology preferences are. To find out more about the cookies that we use, their purpose and how you can manage them, please visit: How we use Cookies

MSCI Disclaimer

Source: MSCIThe information obtained from MSCI and other data providers, included in reports available from this website, may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information and that of other data providers is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling or creating any MSCI information (collectively, the “MSCI Parties”) and other data providers, expressly disclaim all warranties (including, without limitation any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party or other data provider have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages.